ESM / EFSF: An Inverted Capital Structure

I've been meaning to write about this for quite some time, but it's been really hard to have the time to sit down and do it. I've let perfect be the enemy of good and so here I'll try to lay out a rough sketch of what I think are some of the possible risks of the EFSF / ESM.

From Reuters:

The euro zone's permanent bailout fund, the European Stability Mechanism ... which will have an effective lending capacity of 500 billion euros, will be backed by 80 billion euros of paid-in capital and 620 billion euros of callable capital ... It will offer loans at funding costs plus 200 basis points for loans up to three years and plus another 100 basis points for loans longer than three years.

What you are seeing here is what Michael Pettis described as an "inverted" capital structure in his excellent book, The Volatility Machine. What that means is that there is positive correlation between the need for funds, the cost of funds and the credit quality of the facility. This is problematic because it could cause reflexive price action in the bonds of the aid recipients, lowering the value of the EFSF holdings and furthermore deteriorating its perceived credit quality. This is also sometimes referred to as "wrong-way risk" when talking about CCPs. In other words, "the risk that different risk factors be correlated in the most harmful direction." AKA a vicious cycle.

Here's some numbers from the June 7, 2010 EFSF execution agreement. They represent the subscription amount and percentage to the EFSF.  The EFSF is just a legal entity where various countries contribute capital and become equity holders (with unlimited liability). The contributed capital and proceeds from bond issuance are used to make loans to countries that need aid. The bonds are guaranteed by the full faith and credit of the EFSF, the EFSF equity holders (EUM member states), the EU, and have the EFSF holdings as collateral. The table below is a breakdown of the contributed capital so far. Issued debt is to be overcollateralized at a rate of no less than 120% by AAA Holdings and AAA guarantees. There is also to be a cash reserve that equals the NPV of the margin of the EFSF loan and service fee. The EFSF is available to all EMU member states.

ECB Member State	Capital subscription	Contribution Key %
Kingdom of Belgium	2.4256	3,475494866853410%
Federal Republic of Germany	18.9373	27,134106588911300%
Ireland	1.1107	1,591454546757130%
Kingdom of Spain	8.3040	11,898297070560200%
French Republic	14.2212	20,376693436879900%
Italian Republic	12.4966	17,905618879089900%
Republic of Cyprus	0.1369	0,196155692312101%
Grand Duchy of Luxembourg	0.1747	0,250317015682425%
Republic of Malta	0.0632	0,090555440132394%
Kingdom of the Netherlands	3.9882	5,714449467342010%
Republic of Austria	1.9417	2,782143957358700%
Portuguese Republic	1.7504	2,508041810249100%
Republic of Slovenia	0.3288	0,471117542967267%
Slovak Republic	0.6934	0,993530730819656%
Republic of Finland	1.2539	1,796637126297610%
Hellenic Republic	1.9649	2,815385827787050%
Total	67.8266	100,000000000000000%

Where is the risk? Well, the risk here is that everyone is guaranteeing everyone. So, if Ireland Portugal and Greece need aid, their guarantee is pretty much worthless, and they are now users of the fund. If another state were to need aid, another piece of the guarantee would become worthless and need for funds would increase. This would increase the cost of funds, which would be passed on to aid receivers. Unless the states receiving aid are running a budget surplus, this would translate to increasing borrowing needs to cover additional debt service costs, furthermore deteriorating their quality.

Of course, losing Portugal's guarantee is unlikely to be disastrous, but if Belgium and Spain were to find themselves in trouble too, that would put additional pressure on the remaining members, affecting their own credit quality. While it might be no more than an inconvenience to Germany or France, it could adversely affect smaller economies. It could, in essence, leave France Germany and Italy holding the collective bag. I have no clue as to the probability of this happening, but the risk is present and shouldn't just be ignored. If we were to think of bonds as way deep out-of-the-money options (this model goes beyond of the scope of this post), you would notice that you are basically short a lot of gamma here. As the situation deteriorates, the speed at which it deteriorates increases. Of course there is the possibility that it will all work out, which is what the EU is banking on.

I'm not going to get into the gritty part of of this until I have more time, but I think the best way to think about it is as a highly-levered, short way-out-of-the-money put on the EU sovereigns. The probability of going into moneyness might be remote, but the damage in that case would be catastrophic. Buy the paper at your own risk.